10/28/2009 @ 12:00AM

Fiddling Over Reform

For the past year, former Federal Reserve Chairman Paul Volcker–head of the president’s external advisory committee on financial reform–has been thinking carefully about the roots of the financial crisis. He has reflected on a regulatory structure, the Banking Act of 1933, frequently referred to as the Glass-Steagall Act, that worked pretty well for several decades until it was undermined by innovation and the lobbying efforts of financial market participants. The conclusion he has reached is that the best way to regulate the financial system going forward is to go backward to a framework mandated by Glass-Steagall that isolates commercial banking from investment banking and other risky activities.

The only viable solution, in the Volcker view, is to break up the giants. JPMorgan Chase would have to give up the trading operations acquired from Bear Stearns. Bank of America and Merrill Lynch would go back to being separate companies. Goldman Sachs could no longer be a bank holding company. It would be a major restructuring.

Going back to a simple structure that worked is an appealing idea. Although I don’t think it is the best solution to the problem of regulatory reform, for reasons that I will detail below, it isn’t completely crazy. Many others have come to same conclusion. Mervyn King, the Governor of the Bank of England, suggested last week that separating core aspects of banking from riskier activities could reduce the chance that a bank failure could put the whole financial system at risk. He also said that banks should not be allowed to become “too important to fail,” a view held by many–even those who don’t think a modern Glass-Steagall is the answer.

Nevertheless, Volcker was rebuffed publicly by the administration he serves and King was openly ridiculed by Gordon Brown and Alistair Darling for proposing to break up the banks. Both the U.S. and the U.K. are embarked on other approaches to regulation.

Much of the ensuing discussion in the media and among policymakers was completely puzzling and seems to have missed the point entirely. Many were quick to point out that separating commercial and investment banking doesn’t prevent failure. Gordon Brown said: “Northern Rock was effectively a retail bank and it collapsed. Lehman was effectively an investment bank without a retail bank and it collapsed. So the difference between having a retail and investment bank is not the cause of the problem.”

Preventing failure was never the issue to be solved. Making failure possible and less threatening to the whole financial system was and is the problem. The very notion that some institutions are too big or too complex to fail is at the heart of the issue, and paradoxically everything that has happened in the months since the financial crisis began has encouraged the remaining institutions to become larger, more complex and more systemically risky.

Another argument against the separation of commercial and investment banking raised in both the U.K. and the U.S. is that if we break them up, they won’t be able to compete effectively against Universal Banks and business will flow elsewhere. This argument is patently absurd. First, there is little or no evidence that the large complex financial institutions manage their businesses more effectively and plenty of evidence that the very complexity of their enterprises can distract them from managing important, profitable lines of business well. Citigroup’s mismanaged credit card franchise is a good example. And there is ample evidence, as my Stern School colleague Ingo Walter points out, that the large complex banks could not manage their internal conflicts of interest and were immersed in numerous scandals that pitted the interests of clients and their investment banks against investors in their mutual funds and other parts of their operations. He also points out correctly that over the decades in which investment banking was separated from commercial banking by law, U.S. investment banks flourished and became the model for the rest of the world.

My argument against a return to Glass-Steagall-like restrictions is that it tackles the wrong problem. The real issue is that some institutions expose the entire financial system to risk by decisions taken within a single firm or business unit. That is what systemic risk is–it pollutes the financial commons. Making financial institutions smaller or simpler doesn’t really address systemic risk. It may make it easier to identify, but it doesn’t fix the problem.

Unfortunately, the alternatives being discussed in Washington and by the Obama administration don’t address the issue very directly either, but there are signs of progress. One encouraging sign is that Fed Chairman Ben Bernanke has come out in favor of a resolution authority, much like that of the FDIC for insolvent systemic institutions. That is a critical component of meaningful financial reform. It is reported that the Treasury and the House Financial Services Committee are drafting procedures that would let them wipe out shareholders, change management, and restructure the debt of large insolvent institutions.

A very hopeful sign is that they are discussing the “polluter pays” principle that I have been writing about for over a year as the way to think about systemic risk. On this view, the way to discourage the accumulation of systemic risk is to measure it, price it and make firms pay for creating it. This, in the long run, offers the most hope for discouraging reckless behavior. More importantly, in the long run, it should help to discourage firms from becoming so large and complex that they cannot monitor it themselves.

The statements emerging from the House Financial Services Committee make it unclear that they really embrace the idea that the polluter should pay. Equally, it is unclear that the Administration is fully willing to embrace the idea that firms cannot be too big to fail and that such unpriced guarantees create more risk and bad decision making. But this is the critical time and this is the critical debate to be having. If we don’t tackle it, we can sit back and wait for the next meltdown.

Thomas F. Cooley, the Paganelli-Bull professor of economics and Richard R. West dean of the NYU Stern School of Business, writes a weekly column for Forbes. He is a contributor to a Stern School book on the financial crisis, Restoring Financial Stability (Wiley, 2009).